We’re Not Related

The IMF just released a policy brief entitled “Rethinking Macroeconomic Policy“, written by Oliver Blanchard (no relation), Giovanni Dell’Ariccia, and Paolo Mauro. One of the conclusions seems to be to increase the inflation target in order to have more room to maneuver to avoid “liquidity traps”.

The crisis has shown that large adverse shocks can and do happen. In this crisis, they came from the financial sector, but they could come from elsewhere in the future — the effects of a pandemic on tourism and trade or the effects of a major terrorist attack on a large economic center. Should policymakers therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks? To be concrete, are the net costs of inflation much higher at, say, 4 percent than at 2 percent, the current target range? Is it more difficult to anchor expectations at 4 percent than at 2 percent?

I can’t help but think this paper should have been titled “Do the Same Thing, Differently”. I don’t think it can be shown that, during the recent crisis, the Fed rushed to the zero-bound as fast as they could and then was stuck. In fact, as inflation expectations were plummeting in Sept/Oct 2008, the Fed Funds Rate was still 2%. Going back in time, if inflation expectations had been dropping from 4%, would that magically have made the Fed aware that their inaction was causing money to become tight? By November 2008, inflation expectations had plummeted to 4.23% below their implicit target of 2% (-2.23%)…so either way the Fed would have hit the zero lower bound.

The problem, whether a 2% or a 4% inflation target, is that the Fed never credibly committed to hitting any target. In the future creating expectations of higher inflation would, of course, cushion a fall…but not if the Fed conveniently forgets all of modern macro as soon as a recession hits.